Tuesday, December 9, 2014

Vigilantes, Bond and Otherwise

A "bond vigilante" is an investor who sells off sovereign debt because of worries about inflation risk. Remember that Treasury securities, with the exception of 10-year inflation-protected bonds (TIPS), are all fixed-coupon, which means that holders earn a periodic nominal payment. If you add up all these payments (including how much you get for retiring the bond) over the life of the bond, applying a multiplier to each payment to correct for the opportunity cost of waiting for your money to come in, you obtain the present discounted value of it, which in a thick market, should be the price.

So it should be obvious why expected future inflation should make bonds cheaper: ten bucks is worth more in a future where it can buy you two burritos rather than a future where it gets you only one. So while all-a-tizzy, bond investors pay very close attention to the pronouncements of the Federal Reserve, as well as the many lending institutions that actually create money in circulation to estimate future inflation. If they smell it on the wind, they descend like a troop of howler monkeys, selling Treasurys enough to drop the price, which necessarily increases yield, which has the knock-on effect of increasing the cost of sovereign borrowing (if you're a buyer, you have no incentive to discriminate between a new-issue instrument and one on the secondary market). So quite naturally, those folks predisposed to commiserate with the Treasury have dubbed bond investors worried about inflation enough to put their fortunes at stake "vigilantes."

As an undergraduate, I found this choice of terms risible. Vigilantes are lawless, after all. Vigilantes are either an unruly mob, or a lunatic who takes the law into his own hands. Someone who sells off bonds when it's the sovereign who's been naughty is just a prudent investor.

Recent developments have encouraged me to revisit my prejudices.

When the law itself is lawless, vigilantism is the last refuge of the citizen to maintain the public order. When beat cops (to pick a fanciful example) disregard their duty to prosecute violent offenders in favor of harassing pedestrians, when state troopers pull over drivers with out-of-state plates in search of enough paraphernalia to justify an on-site takings, when vice cops rape street walkers in lieu of investigating coerced child prostitutes, then the principal-agent problem has ballooned out of control, and an arbitrage opportunity arises for law-and-order entrepreneurs. In the vernacular, we call these people "vigilantes," but try to ignore the connotation and focus instead on the actual deeds.

So the question of moral intuition: under what conditions would a randomly-selected constituent approve of vigilantism? How badly do the sovereign and his agents have to abdicate responsibility before citizens taking the law into their own hands is preferable? More to the point, isn't there a natural incentive to maximize institutionalized misconduct subject to the constraint of outright revolt? Isn't it in the natural interest of the Sovereign to abuse and exploit his subjects to encrease his dominion? If not, why not?

A vigilante is someone who challenges the state monopoly on violence. A bond vigilante is someone who challenges the state monopoly on the issuance of sovereign debt. Can a vigilante be euvoluntary? I suppose that depends on the alternatives.

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Do you have suggestions on where we could find more examples of this phenomenon?